How to Handle Investments that Have Tax Advantages

Bob Carlson


Last week, I explained why assets without tax advantages should generally be held in tax-deferred or tax-free accounts.

Today, let’s dig into assets that do have tax advantages… and how to best handle them.

As a rule, investments with their own tax advantages should be held (in most cases) in taxable accounts.

As you know, stocks and stock mutual funds that you plan to hold for more than one year qualify for long-term capital gains… and are the obvious candidates for taxable accounts.

Stocks with high dividend yields are often best held in taxable accounts when the dividends are “qualified dividends,” subject to a maximum 20% tax rate. Most dividends paid by U.S. corporations are qualified dividends.

Now, let’s examine some situations in which the general rules aren’t the best advice.

My number-crunching over the years revealed that details determine when stocks, whether purchased individually or through mutual funds, should be in a taxable or tax-advantaged account.

Mutual funds require the most analysis, even if you’re planning to own the funds for more than one year.

A mutual fund distributes most of its net gains and income to shareholders by the end of each year. They are included in your gross income, even if you choose to have the distributions reinvested. A mutual fund that does a lot of trading during the year can distribute a substantial portion of its appreciation to shareholders. Long-term gains and qualified dividends earned by a fund are taxed that way to shareholders, but short-term gains distributed by a fund are ordinary income to shareholders.

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The result?

You might hold a stock fund for the long-term, but a good portion of the appreciation will be taxed to you each year; they might even be taxed as ordinary income.

The general rule is a good one when your stock mutual funds or your stock portfolio are tax efficient. When you own mutual funds that make low annual distributions, and you don’t take gains on your mutual funds or stocks after holding them under a year, the stocks and stock mutual funds should be in a taxable account.

But if you own stock mutual funds that often make distributions equal to 20% or more of their annual returns, consider owning them in a tax-advantaged account, especially if the distributions tend to be taxed as ordinary income.

For example, if a fund returns 10% for the year and distributions are 4% or more of its net asset value, it is not tax efficient, and it is best owned through a tax-advantaged account.

There are two other factors to consider.

One factor is the difference between the rates of return on different investments. It usually is advantageous to hold higher returning investments in a tax-advantaged account when there is a difference of five percentage points or more in the annual returns, even when the higher-returning investments are tax advantaged.

This is especially true when you anticipate leaving the investments in the tax-advantaged accounts for a decade or more so the higher returns can compound.

The conventional wisdom is really turned on its head when Roth IRAs and other tax-free accounts are considered.

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When you are able to earn significantly higher returns from stocks or other investments, you’ll have more lifetime after-tax income when those gains compound tax-free in a Roth IRA, and then tax-free when distributed.

Unless you’re a very tax efficient investor (an annual tax rate of 5% or so on your investment returns) or there’s not much of a difference between returns on your different investments, it’s often better to hold the low-returning, ordinary income investments, such as bonds, in taxable accounts.

The longer the compounding period, the more valuable the tax-free account is.

The second factor is the difference between your tax rates.

When you are in the highest income tax bracket, getting the location allocation right can save substantial tax dollars over your lifetime. But when you’re in the middle or lower brackets, and there isn’t as big a difference between the ordinary income tax rate and long-term capital gains rate, you’ll still be better off with the optimal asset location, but you won’t reap as much reward as a high-bracket investor.

There are also two long-term factors that merit some consideration.

When you plan to hold an appreciating investment for life, it makes sense to hold it in a taxable account. Your heirs will inherit it and immediately increase the tax basis to current fair market value. They can sell it and not owe any taxes on the appreciation that occurred during your lifetime. They don’t have that advantage in a tax-deferred account.

Also, consider your future tax rate if you think it can be anticipated. The penalty for holding the wrong investments in a traditional IRA or similar account isn’t as high if you’re in a high tax bracket today, but expect to be in a lower bracket when taking distributions.

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Of course, once you decide to own an investment in a taxable account, you should try to manage that account as tax efficiently as you can.

Remember, owning the right assets is the most important decision. But when your nest egg is spread among different types of accounts, it makes sense to try to optimize the location of your investments.

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